Household saving is defined as the difference between a household’s disposable income (wages, income of the self-employed and net property income) and its consumption (expenditures on goods and services.)

Assessing True Value

Advertisement

May 04, 2011

SPONSORED STATEMENT: BNY MELLON

BNY Mellon’s new currency analysis tool provides a fresh perspective — and much-needed clarity — in the complex world of foreign exchange.

One of the greatest challenges in foreign exchange markets is to understand the longterm influences on a currency’s value. Market sentiment, data releases and official commentary can obscure such trends by exacerbating short-term price movement. To be sure, a currency’s value is impacted by net cross-border trade and investment flows. All things remaining the same, the larger the trade surplus and the greater the inflow of foreign investment, the greater the demand is for that country’s currency. Economists have a convenient measure for these flows that is derived from the balance of payments called the broad basic balance (BBB). The BBB is simply the sum of a country’s current account, foreign direct investments (e.g. funding a new manufacturing plant) and net portfolio investment for a given period. In using balance of payments data, it is better to use non-seasonally adjusted data as a currency’s value is impacted by actual rather than smoothed trade and investment flows.

BNY Mellon recently launched the Balance of Payments (BOP) Insight, an FX research product designed to identify the fundamental drivers of a currency’s real value over time. The BOP Insight is a decision-support tool that provides a consistent methodology across a broad range of currencies to help identify both fair value as well as over/under valuation. This type of analysis can be useful regardless of whether a currency is fixed, managed or freely floating. Countries and currency blocs initially covered by the BOP Insight include the United States, the Eurozone, Japan, the United Kingdom, Switzerland, Canada, Australia, New Zealand, Brazil and Mexico. Country coverage will change over time to reflect the interests of BNY Mellon’s client base.

Balance of Payments (BOP) Insight is a BNY Mellon FX research product designed to identify the fundamental drivers of a currency’s real value over time

A currency’s strength over time can be measured in a number of ways. Market players often use the nominal change of a currency’s spot price against the US dollar to measure the change in its value over time. However, there are two drawbacks to this approach. First, a currency’s value against the US dollar does not fairly reflect its value against all currencies. Underlying strength or weakness in the US dollar would have a material impact. A trade-weighted currency measure better reflects a currency’s nominal value by weighting it against the currencies of its largest trading partners. Second, a currency’s nominal value does not fairly reflect its value in purchasing power when there are material differences in inflation over time. Inflation is corrosive to the real value of a currency, and therefore we need to have an inflationadjusted measure to accurately reflect the impact of trade and investment flows. The real effective exchange rate (REER) is both a trade-weighted and inflation-adjusted measure of a currency.

Comparing a country’s REER with its BBB can be useful for currency analysis when measured over long periods of time, typically 5-10 years. Balance of payments data is updated by each country’s economic authorities on either quarterly or monthly basis, and thus it requires longer time horizons to appreciate the series’ underlying trend. Likewise, given that currency prices, even the REER, can be impacted in the short-term by market sentiment, data releases and official commentary, it also requires longer horizons to appreciates its underlying trend. When comparing the BBB and the REER over long horizons, one also needs to cumulate the data to reflect the cumulative impact that trade and investment flow are having on the currency over time. This type of analysis is useful in several respects. It can help to identify the direction of a currency’s value, it can help to identify the driver’s of a currency’s value, and it can help to identify deviations from a currency’s fair value.

The BOP Insight finds a high positive correlation between a country’s BBB and its currency’s REER. Simple correlations frequently run as high as 70-80%, dependent upon the period specified. In some cases, such as Japan, the cumulative impact of periodic current market intervention can reverse the relationship between the BBB and the REER, which can be particularly useful in understanding the extent of a currency’s current value from what it would have otherwise been in the absence of intervention. In other cases, such as the United States, a currency’s status as a primary reserve currency can alter the relationship between the BBB and the REER. In this case, given currency intervention and commodity sales take place largely in US dollar terms, it is necessary to include foreign official demand for US Treasuries in the BBB of the United States. Regardless of the country, clients will find that the BOP Insight provides a fresh and unique perspective in the often complex world of foreign exchange.

The BOP Insight can be accessed via the BNY Mellon website (gm.bnymellon. com/BOP), and will soon be available as part of a BNY Mellon mobile app that will bring BNY Mellon Global Markets Research to smart phones and other mobile devices.

The BOP Insight is a powerful decision support tool

While the current account and foreign direct investment are structural in nature and relatively stable over time, portfolio investment is not. Such “hot money” is susceptible to short-term changes in the economic environment, changes in investor sentiment and ultimately changes in the price for stocks and bonds. Consequently, while the BOP Insight is a powerful decision-support tool, it is more an explanatory model than a predictive model. To accurately forecast a currency’s value, one needs both an understanding of a currency’s long term drivers as well as access to a real-time monitor of net portfolio investment. In this sense, the BOP Insight complements another BNY Mellon FX research product—the iFlow. The iFlow utilizes data from the $25.5 trillion BNY Mellon global assets under custody and administration to provide an accurate, real-time monitor of cross-border investment. Using both iFlow and the BOP Insight, clients can better anticipate changes in a currency’s value due to changes in foreign investment. With this advantage in the marketplace, BNY Mellon clients can focus more on making the right investment or business decision rather than focusing on changes in foreign exchange prices.

Michael J. Woolfolk is a managing director and senior currency strategist in the Global Markets business of The Bank of New York Mellon. Woolfolk joined the bank as a currency strategist in 1996. Before joining BNY Mellon, he worked at Credit Suisse First Boston as a currency analyst in their London and New York offices. Woolfolk graduated from Penn State University in 1995 with a Ph.D. in finance. His doctoral dissertation, An Empirical Analysis of Taxable Stock Distributions documented for the first time that corporate spin-offs created value for both the parent and spin-off companies regardless of the tax status of the distribution. Dr. Woolfolk is currently an adjunct faculty member of New York University and teaches courses in international economics. As the sole press contact for the New York dealing room, he appears regularly on television and radio and is frequently cited in the financial press. Global Finance magazine ranked BNY Mellon first in the world for currency research in its latest annual survey.